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Transcript of NATURAL DISASTERS AND MACROECONOMIC PERFORMANCE: THE cege/Diskussionspapiere/DP194.pdf ·...

  • ISSN: 1439-2305

    Number 194 September 2014

    NATURAL DISASTERS AND

    MACROECONOMIC PERFORMANCE:

    THE ROLE OF RESIDENTIAL

    INVESTMENT

    Holger Strulik, Timo Trimborn

  • Natural Disasters and Macroeconomic Performance:

    The Role of Residential Investment

    Holger Strulik

    Timo Trimborn

    First Version: March 2014. This Version: September 2014

    Abstract. Recent empirical research has shown that income per capita in the aftermath

    of natural disasters is not necessarily lower than before the event. In many cases, income is

    not significantly affected and surprisingly, can even respond positively to natural disasters.

    Here, we propose a simple theory based on the neoclassical growth model that explains

    these observations. Specifically, we show that GDP is driven above its pre-shock level

    when natural disasters destroy predominantly residential housing (or other durable goods).

    Disasters destroying mainly productive capital, in contrast, are predicted to reduce GDP.

    Insignificant responses of GDP can be expected when disasters destroy about equally

    residential structures and productive capital. We also show that disasters, irrespective of

    whether their impact on GDP is positive, negative, or insignificant, entail considerable

    losses of aggregate welfare.

    Keywords: Natural Disasters; Economic Recovery; Residential Housing; Economic

    Growth.

    JEL: E20, O40, Q54, R31.

    University of Goettingen, Faculty of Economic Sciences, Platz der Goettinger Sieben 3, 37073, Goettingen,Germany, Email: [email protected] University of Goettingen, Faculty of Economic Sciences, Platz der Goettinger Sieben 3, 37073, Goettingen,Germany, Email: [email protected]

  • 1. Introduction

    In this paper, we propose an economic theory to analyze the macroeconomic effects of natural

    disasters. We mainly focus on hydro-meteorological disasters (e.g. floods, storms, droughts) and

    geophysical disasters (e.g. earthquakes, tsunamis), and the physical and monetary damage caused

    by these disasters. As documented by Cavallo and Noy (2011), these types of disasters are fairly

    common events across the globe, and occur with increasing frequency. For example, in the Asia-

    Pacific region, the most afflicted region, the incidence of natural disasters increased from 11 events

    per country in the 1970s to 28 events in the 2000s. In Western Europe, events per country and

    decade increased from 5 to 15 over the same time period.

    To date, there exists a large and increasing empirical literature investigating the economic

    impact of natural disasters (e.g. Raddatz, 2007; Noy, 2009; Loyza et al., 2012; Fomby et al.,

    2013; Cavallo et al., 2013; see Cavallo and Noy, 2011 for a survey). One perhaps surprising

    conclusion suggested by the literature is that disasters do not necessarily decrease GDP per capita

    in the aftermath of the event. Loayza et al. (2012), for example, find no significant impact on a

    countrys GDP and industrial output across all disasters. In contrast, when floods are investigated

    separately, they are found to stimulate GDP while droughts are found to harm GDP in developing

    countries (but not everywhere). Similarly, Fomby et al. (2013) find a positive effect of floods and

    a negative effect of droughts but no effect of earthquakes and storms on post-disaster GDP in

    developing countries. In developed countries, all types of disasters appear to exert no significant

    impact on GDP. Using counterfactual analysis, Cavallo et al. (2013) find that disasters exert no

    significant influence on short- and long-run output when they control for potential post-disaster

    outbreak of social conflict.

    These empirical observations seem puzzling when analyzed within the context of conventional

    neoclassical growth theory. Once we acknowledge that disasters destroy (potentially severely)

    the productive potential of an economy, we would expect that they then harm the subsequent

    economic performance. It is true that the neoclassical growth model predicts that the growth rate

    after an exogenous loss of capital stock (or other productive factors) is positive. This phenomenon

    is known as catch-up growth from below towards the steady-state. GDP per capita, however, is

    predicted to fall short of its pre-disaster level according to conventional growth theory.1

    1The disaster literature, confusingly for growth economists, refers sometimes to the differential between pre- andpost-shock levels of GDP as GDP growth (e.g. Loayza et al., 2012). This differential is predicted by the standardneoclassical growth model to be unambiguously negative. Moreover there exists also a smaller literature investigating

    1

  • In this paper, we show how a simple extension of the neoclassical growth model can be used

    to reconcile theory with empirics and how the model can be used to motivate the diverse post-

    shock macroeconomic outcomes found in the disaster literature. The key ingredients are the

    introduction of variable labor supply and the distinction between productive capital stock and

    residential housing (and other durable goods). In line with conventional theory, the model predicts

    that an exogenous loss of capital stock reduces post-disaster GDP. An exogenous loss of residential

    housing, in contrast, drives GDP above its pre-shock level. The reason is that individuals, suffering

    from the implied wealth shock, supply more labor in order to (quickly) rebuild the damaged houses

    (and other damaged durable goods such as cars). Since firm capital remained undestroyed, the

    increased labor supply implies higher GDP per capita during the reconstruction phase.

    Considering simultaneous shocks on both state variables, the model predicts a negative im-

    pact on GDP for disasters destroying predominantly productive capital and a positive impact on

    GDP for disasters destroying predominantly residential housing. No significant effect on GDP

    is predicted when the effects on firm capital is slightly smaller compared to that on residential

    housing. The theory is not only helpful to explain the frequently insignificant impact of disasters

    on GDP, it can also rationalize those cases for which the literature finds significant GDP effects.

    Intuitively, we may expect that droughts exert a negative impact on GDP because they leave

    residential housing mostly intact and destroy predominantly firm capital. This is in particularly

    the case in largely agrarian societies (seeds, livestock). Conversely, we could imagine that floods

    stimulate GDP because they damage predominantly residential housing (and other durable goods,

    like furniture or household appliances). Furthermore, some authors find positive employment ef-

    fects of disasters supporting our proposed mechanism through which output might increase in the

    aftermath of a disaster (see Leiter et al., 2009, Ewing et al., 2009).

    In order to present the mechanics behind the housingchannel in the cleanest way we first

    discuss in Section 3 the case of a small open economy with perfect capital mobility. This exercise

    shuts down the capital-channel because capital stock is pinned down to its steady-state value.

    In this framework, we generally prove that disasters damaging residential housing lead to higher

    output in the short and long-run and we state conditions under which the response of GDP

    is also positive. The reason for the positive effect on GDP is that disasters reduce the wealth

    the association between disaster risk and long-run growth (e.g. Skidmore and Toya, 2002; and Crespo Cuaresma etal., 2008). Here, we focus on the short- to medium-run impact of disasters.

    2

  • of households, which motivates them to supply more labor in order to quickly reconstruct the

    damaged houses and durable goods.

    We then turn to the large economy case and show that the main mechanics of the wealth effect

    are preserved while another amplifying effect occurs through intertemporal substitution. House-

    holds want to reconstruct their damaged houses quickly and increase their residential investments

    in the aftermath of the disaster. Resources for this purpose are freed by reducing investments in

    productive capital and by reducing consumption of nondurable goods. In order to mitigate the

    drop in consumption, households are motivated to raise their labor supply even further, beyond

    what has already been triggered by the wealth effect.

    Our analysis of the individual effects of disasters on firm capital and on residential housing

    shows that GDP can be a very misleading indicator of the economic damage caused by natural

    disasters. This is most obvious when we compare a disaster that destroys only productive

    capital with another one destroying additionally residential housing. The GDP damage is larger

    for the first one while the welfare loss is larger for the second one. At the end of the paper, we

    perform a welfare analysis for a numerically specified version of the model and find large welfare

    losses from natural diasters that leave GDP more or less unaffected.

    The paper is organized as follows. The next section introduces the general model. Section 3

    presents the case of a small open economy and Section 4 presents the closed economy case. In the

    main text, we assume that households own their houses. In the Appendix, we show robustness

    of results against an alternative setup in which households rent housing servi